There has been some debate recently about the suitability of lifestyling as an investment strategy for DC schemes. It’s often suggested that one drawback of lifestyling is that it only targets the need for buying an annuity and maximum cash lump sum on retirement. Furthermore, many members don’t retire on their normal retirement date (NRD). However, lifestyling caters for the majority of member needs and NRDs are necessary to target the changing asset allocations over the member’s working life. This is especially required for disengaged members who are unlikely to re-visit their pension decisions and take advice before phasing starts. According to Mintel research (Occupational and Group Pensions, Finance Intelligence, June 2009), around 80% of DC scheme members have not strayed from a scheme’s default investment strategy, most of which have a lifestyling component. Such disengagement makes adoption of an appropriate lifestyle solution important from the start. However, it’s not possible to design any one strategy to suit all investors due to their varying retirement objectives, risk tolerances, time horizons, size of existing ’pots’, contribution levels and financial literacy.
Effective lifestyle solutions should offer suitably differentiated lifestyle fund choices, spanning the risk-return spectrum to reflect members’ varying risk tolerances. Also, the ability to customise lifestyle strategies creates better-tailored solutions.
Getting the timing right
But is there an optimum phasing period for lifestyle strategies? Transitioning assets from the growth phase to the protection phase too early reduces the opportunity for capital growth. Conversely, switching too late exposes members to investment risk at the time when a large pot has been accumulated, increasing the potential for significant losses with less time to make up any shortfall.
While financial modelling can help in determining the appropriate glide path length, no optimum solution exists. Actual outcomes are significantly influenced by the degree of exposure to equities and the length and magnitude of market cycles. Losses from equities appear to occur more often than some models would suggest. The avoidance of significant losses to a member in the latter growth and early protection stages is vital.
Developments
The desire to reduce volatility and downside risks whilst not sacrificing all growth potential is leading to the increased use of diversified growth funds (DGF) as part of lifestyle strategies. Unlike their more ’constrained’ managed fund counterparts, DGFs have dynamic asset allocation mandates, aiming to reduce the impact of bear markets and to also capture bull market upturns. These funds invest in a broader range of assets such as private equity, property, infrastructure, absolute return funds, commodities and high yield debt. Crucially, much of the lower volatility derives from the lack of correlation between the various assets the fund invests in. One challenge to making DGFs work with contract arrangements is the higher costs involved. This is where increasing member engagement becomes more crucial.
Other lifestyling developments include the addition of emerging market equity exposure in the growth phase and more solutions using corporate debt within the protection phase. Traditionally the annuity matching mechanism, although not perfect, is achieved by investing in long gilts on the basis of the inverse relationship between annuity prices and gilt yields. Corporate debt exposure seeks to provide a return premium relative to gilts through higher credit and liquidity risks. Corporate debt exposure as an alternative to gilts is usually limited and/or decreased towards the end of the protection phase, due to the additional volatility and increased correlation to equities during market downturns.
Lifestyle balance
Although there is no perfect lifestyle solution, for many, lifestyling strikes an appropriate balance between risk and return. Continual development of lifestyle options providing differentiated strategies to suit varying member needs, combined with improved member engagement will make sure lifestyling continues to remain appropriate for the majority of defined contribution pension investors into the future.